Ukraine Is Two Weeks Away From A Meltdown As Forex Reserves Disappear

Ukraine's foreign exchange reserves, essential to supporting the country's fixed exchange rate, have fallen by nearly one-quarter since August, and are now hovering at only a fortnight over the three-month import cover regarded as minimum. With global steel prices on which Ukraine depends continuing to slide and the price of Russian imported gas soaring, it is time for Kyiv to look for external help – but that's easier said than done.

Ukraine's central bank, the National Bank of Ukraine (NBU), reported March 6 that its forex reserves had fallen to only $31bn, which it said is sufficient to finance imports of goods and services for only three-and-a-half months. The central banker's rule-of-thumb says that three months import cover is a minimum to support a currency, giving Kyiv a fortnight to put things right.

Ukraine's reserves peaked at $38.2bn in August, but as the Eurozone crisis unfolded it has been downhill all the way. The NBU lost $3.35bn alone in September as the country's balance of payments turned negative and reserves thereafter continued to haemorrhage, losing $746m this year so far. The current account is booking a deficit of $1.0bn-1.5bn most months, with a small surplus in January 2012 an exception.

The problem is not of Ukraine's own making: the country is facing a double whammy from falling steel prices – making up 40% of export revenues – and a hike in the price of imported Russian gas. Steel prices have dropped globally due to the impact of the Eurozone crisis, and for Ukrainian producers price have fallen by over 20% since September. As a result, steel production fell 7.7% in February on the year, according to Bloomberg.

More worrying is that it isn't just the Eurozone crisis that is impacting the steel industry. The increasing slowdown of the Chinese real estate market will impact heavily on the price Ukraine can get for its steel in 2012 and thus the volume that it will produce. "We expect a steel price decline in the next three-five months as construction volumes in China start to decrease," says Erste Bank's Ukraine analyst, Maryan Zablotskyy. "Ukrainian steel mills will find it difficult to fight lower prices."

At the same time as revenues from steel exports slump, the price of Russian gas imported by Ukraine spiked by 21% in January to $416 per thousand cubic metres as a result of the oil price surge in 2011 prompted by unrest in the Arab world. Ukraine's gas bill came to $1.1bn in February.

In addition, Kyiv has to make $6.0bn in debt repayments in 2012, of which $3.5bn is repayment to the International Monetary Fund (IMF) – the first tranche of which was paid in February.

While the external blows are not the fault of the government, the slide in reserves has been exacerbated by Ukraine's central bank clinging to a fixed exchange rate, whereas regional peers such as Russia and Turkey have let their currencies weaken. The reason: Ukrainian companies and households are still heavily leveraged in foreign currency as a result of the credit boom in the run-up to 2008. The World Bank said in February that it puts the level of non-performing loans in Ukraine at 40% of total. The government fears that any devaluation would see this figure soar, while scaring the population into withdrawing deposits and converting them into dollars.

No exit

Ukraine should not be facing any disorderly devaluation let alone default because it has not one, but two exits waiting for it with open arms – albeit each with a steely embrace.

One possible exit from its current woes would be a new deal with the IMF – but that would entail another sharp rise in the price of gas supplied to the population and to utilities, which the government is loath to do going into parliamentary elections October 2012. "The IMF's demand to raise the price of gas for households by 50% is unacceptable to us – we will not agree and will never agree to this," President Viktor Yanukovych stated categorically on March 6.

Yanukovych's Party of Regions is going into crucial parliamentary elections in October with falling ratings, partly it believes due to earlier agreements with the IMF to hike utility prices and the pension age. Moreover, it is widely believed that a good part of subsidised gas provided to the population is in fact diverted to industrial companies linked to government backers, constituting a hidden subsidy to well-connected industrialists.

But it is not just the requirement for Ukraine to raise the price of gas that is keeping the IMF away from Ukraine. The US-dominated body is also widening its mandate to cover democracy, and this bodes ill for Ukraine, which the West has criticized for jailing two leading opposition leaders, former prime minister Yulia Tymoshenko and former interior minister Yury Lutsenko. US Assistant Secretary of State Philip Gordon in comments on Ukrainian TV on February 13 indicated that more democracy, ie. releasing Tymoshenko, would be a condition for renewed IMF funding. And Chris Jarvis, head of the IMF mission to Belarus said March 5 that the IMF could not respond to dictatorship Belarus' request for financial support until it was "confident that a new programme would be supported by the IMF’s membership," ie. get the political green light from the West. The IMF then March 6 announced that Jarvis would be the IMF's new man for Ukraine – go figure.

With the IMF playing tough, Ukrainian hopes are pinned on Russia's new president returned, Vladimir Putin. In comments made on the day of his election victory March 4, Putin confirmed that he would make the former Soviet states his foreign policy priority, and as part of the build-up to the elections he had proposed the creation of an EU-style Eurasian Union. Ukraine would be the lynchpin in such plans, but even the Russia-friendly Yanukovych administration has claimed that its destination is Europe and without Ukraine, any Eurasian Union would be simply Russia and some minnows.

Ukraine is begging for a gas price rebate from Russia that would solve the current account deficit problem and conserve reserves, but Gazprom has to date offered only a miserly 10% that it afforded to other European customers – unless Ukraine follows in Belarus' footsteps and gives Gazprom a stake in its transit pipeline system. If so, Ukraine could count on its gas price being halved and generous provision of credits. But this again could prove costly when it comes to parliamentary elections – the gas pipelines are regarded as Ukraine's chief "strategic asset" and a decision to divest control will be regarded as treachery by part of the electorate.

Ukraine's best bet now – aside of course from releasing Tymoshenko and Lutsenko – is that the newly-elected Putin, looking to get off to a good start with Ukraine and his foreign policy, might now choose to soften these conditions in return for some woolly commitment by Kyiv to the Eurasian bloc. Putin has said his first foreign visit as president would be to a CIS state and this likely means Ukraine. But Putin's inauguration is scheduled for May, so he won't make it to Kyiv in his new role for another six weeks. And with the pace of events heating up as Greece and Europe wobble, this may even prove too late for Ukraine.